Enron used them to hide losses and invent earnings. Intel and Hewlett-Packard used one to wall off the technology behind the Itanium chip. A bank uses one every time it packages loans into a mortgage-backed security. The tool is the special-purpose entity, or SPE.
It goes by other names, including special-purpose vehicle and financial vehicle corporation. One formal definition calls it “a fenced organization having limited predefined purposes and a legal personality.” In practice it is usually a limited company, sometimes a limited partnership, set up for a narrow or temporary job.
Companies typically move assets into an SPE to manage them, or use one to finance a large project, so the whole firm is not put at risk. A company that sponsors an SPE has to keep its distance from it. Without enough distance, the new entity is just a subsidiary, not an SPE. Many are set up as “orphan” companies, with shares held by a charitable trust and professional directors supplied by an administration company, so that no connection to the sponsor exists.
The reason matters in securitization. Say a bank wants to issue a mortgage-backed security paid out of a pool of loans. Holders need first claim on those payments, so the loans have to be legally separated from the bank’s other obligations. The bank creates an SPE and transfers the loans into it. If the bank owned or controlled that SPE, it would be consolidated with the bank’s group for regulatory, accounting and bankruptcy purposes, and the exercise would be pointless.
Other uses
Multi-tiered SPEs allow several layers of investment and debt. Some companies use one to isolate a high-risk project from the parent and let outside investors share the risk.
Permits are another reason. Many permits needed to run a power plant, for example, cannot be transferred or are hard to transfer. If an SPE owns the plant and all its permits, the SPE can be sold as one package instead of reassigning each permit. Public-private partnerships across Europe, which rely on project-finance structures, lean on SPEs in a similar way, letting several businesses contract with a public body.
Others are less benign. SPEs are commonly registered in tax havens, where they allow tax avoidance strategies not available at home, round-tripping among them. An SPE inside an orphan structure can also be used to get around rules such as limits on the nationality of ownership of certain assets. Some tanker fleets put each ship in its own SPE to try to avoid group liability under broad anti-pollution laws.
When they fail
An SPE should be able to stand on its own, independent of the sponsor. That does not always happen. One reason the Enron SPEs collapsed was that they became a vehicle for the parent’s own ends, in breach of prudential norms of corporate financing and accounting. Executives used them to hide losses and fabricate earnings, which led to the Enron scandal of 2001.
Towers Financial Corporation did the same and declared bankruptcy in 1994. Several of its executives were found guilty of securities fraud, served prison sentences and paid fines. Evergrande has also been accused of using SPEs to hide debt.
Accounting rules now address them. Under US GAAP, FIN 46R sets out how these entities are consolidated. Under international standards, IFRS 10 has superseded IAS 27 and SIC 12 for periods beginning on or after 1 January 2013.
